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Hedge Funds Struggle Amid Manager Scandals

Hedge funds scared off investors because of scandals, though interest is starting to return.

NEW YORK (TheStreet) -- Some of the biggest victims of the Madoff scandals were investors who relied on vehicles known as funds of hedge funds. Hundreds of millions of dollars vanished from funds of funds run by Maxam Capital Management and Tremont Group Holdings.

Shaken by the losses, investors fled funds of funds. Withdrawals totaled $158 billion in 2008 and 2009, according to industry tracker

Hedge Fund Research

.

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Part of what unnerved investors was that funds of funds had long been seen as relatively safe choices. The funds typically collect money from investors and put it into a pool that includes 20 or more hedge funds. The aim is to provide broad diversification. Funds of funds claim to offer security because professional managers pick the hedge funds that go into the portfolios.

But as the revelations about Madoff unfolded, it became clear that some funds of funds had been deceptive. One portfolio had all its assets in three funds, and one of them was Madoff. Hurt by the Ponzi scheme, returns of funds of funds suffered. The group lost 20% in 2008, trailing single-manager hedge funds by 4 percentage points, according to Hedgefund.net.

Will funds of funds continue losing investors? Probably not, says Peter Laurelli, vice president of

Channel Capital Group

, which operates Hedgefund.net. "The funds of funds are stabilizing, and they are starting to report inflows," he says.

Laurelli says total assets in funds of funds reached $1.4 trillion in the second quarter of 2008. Then the figure hit a trough of $820 billion in the second quarter of 2009. In the first quarter of 2010, the total climbed to $913 billion.

Funds of funds have long been a major factor in the hedge fund world. In 2004, 54% of all assets in hedge funds came through funds of funds. Today funds of funds account for 40% of all hedge fund assets.

Funds of funds appeal to a variety of investors. Individuals with several million dollars to invest may prefer putting the cash into a diversified fund of funds instead of relying on one or two hedge funds. The convenience of one-stop shopping also appeals to pensions and endowments with limited investment staffs. In many cases the funds of funds have proven to be competitive investments. Laurelli says that since 2001, funds of funds have returned 4.4% annually, a decent showing in a period when the S&P 500 was about flat.

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In the past, top funds of funds had little trouble attracting investors. As a result, portfolio managers could charge stiff fees and reveal little about their holdings. Now the old ways are changing as investors win more concessions.

In the traditional arrangement, investors paid two layers of fees. First, the funds of funds charged annual management fees of 1% of assets and performance fees that were 10% of profits. The second layer of fees went to the underlying hedge funds, which often imposed management and performance fees.

To satisfy investors, some funds of funds have been shaving their performance fees down to 5% or less, says Amy Bensted, manager of hedge funds for

Preqin

, which tracks alternative investments. "In the last year or two, there has been a lot of pressure on managers to cut their fees," she says.

Many managers have been taking steps to become more transparent. In the past, some top funds of funds provided only annual shareholder letters that offered limited disclosures about portfolio holdings. Now some funds provide monthly disclosures that include detailed information about each hedge fund in the portfolio.

To obtain more disclosures, some investors are leaving funds of funds and turning to different vehicles called managed accounts, says Scott Esser, chief operations officer of Hedge Fund Research. The typical managed account platform may include a group of 100 hedge funds. Clients sit down with a manager and pick a customized portfolio of about 25 of the funds. "The funds of funds model is not dead, but more people will turn to managed accounts so that they can control where their dollars go," Esser says.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.